Is it time to regulate proxy advisory firms?

The idea of regulating proxy advisory firms has been in the ether for quite some time, but it’s an idea that never quite comes to fruition. However, there seems to be a lot of chatter about this topic now, raising the question: is now the time? According to this paper, The Big Thumb on the Scale: An Overview of the Proxy Advisory Industry, from Stanford’s Rock Center for Corporate Governance, while proxy advisory firms influence institutional voting decisions and corporate governance choices to a material extent, it “is not clear that the recommendations of these firms are correct and generally lead to better outcomes for companies and their shareholders.” In that light, the paper suggests that some type of regulation of proxy advisory firms might be warranted to increase their transparency and improve the reliability of their recommendations.

The idea of regulating proxy advisory firms has been in the ether for quite some time, but it’s an idea that never quite comes to fruition. However, there seems to be a lot of chatter about this topic now, raising the question: is now the time? According to this paper, The Big Thumb on the Scale: An Overview of the Proxy Advisory Industry, from Stanford’s Rock Center for Corporate Governance, while proxy advisory firms influence institutional voting decisions and corporate governance choices to a material extent, it “is not clear that the recommendations of these firms are correct and generally lead to better outcomes for companies and their shareholders.” In that light, the paper suggests that some type of regulation of proxy advisory firms might be warranted to increase their transparency and improve the reliability of their recommendations.

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There have been numerous attempts at regulating proxy advisory firms. The SEC’s 2010 proxy plumbing concept release suggested requiring proxy advisory firm registration, mandating more disclosure regarding potential conflicts of interest and review processes and filing of proxy advisor recommendations with the SEC. In 2010, the NYSE Commission on Corporate Governance advocated that proxy advisors be held to appropriate standards of transparency and accountability, including adherence to strict codes of conduct and requirements to disclose the policies and methodologies that they use to formulate specific voting recommendations, all material conflicts of interest and the company’s response to the firms’ analyses and conclusions. The Financial Choice Act of 2017, which passed the House but died in the Senate, would have also required registration of proxy advisory firms. (See this PubCo post.) Currently, the Corporate Governance Reform and Transparency Act, H.R. 4015, which is being considered in the Senate after having passed in the House, would require proxy advisory firms to register with the SEC, to make prescribed disclosures, to allow companies to comment on recommendations, to designate an ombudsman, to maintain adequate staffing, to publicly disclose their methodologies for the formulation of proxy voting policies and voting recommendations, and to identify any potential or actual conflicts of interest. Whether the bill will actually pass in the Senate is anyone’s guess. In addition, SEC Chair Jay Clayton has suggested that, for an upcoming proxy process roundtable, reliance by investment advisors and institutions on proxy advisory firms would be a worthy topic, including company rights to contest erroneous information, firm transparency and conflicts of interest. (See this PubCo post.)

Even though most matters on proxy cards are run-of-the-mill, proxy voting can serve as “an important vehicle for shareholders to communicate their preferences to the board.” Some are inherently contentious, such as election contests and takeover proposals. But even annual say-on-pay proposals can send “an important signal about shareholder satisfaction with CEO pay and performance.” The authors cite one 2009 study for the proposition that “protest votes in uncontested director elections are associated with higher board turnover, higher management turnover, and increased corporate activity (such as major asset sale or acquisition) in the year following the vote.” From time to time, shareholder proposals can trigger some heated debate—although they almost always involve non-binding precatory proposals—because proposals that garner a majority vote, or even just a substantial one, can put pressure on boards to address the underlying issue. As a result, many activist shareholders use the shareholder proposal process in an effort to effect change.

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Notably, proxy advisory firms are the source of some of that pressure. For example, in its 2018 voting guidelines, ISS indicates that it will take board responsiveness into account in making determinations about votes for director. More specifically, the guidelines state that ISS will vote “case-by-case on individual directors, committee members, or the entire board of directors as appropriate if [the] board failed to act on a shareholder proposal that received the support of a majority of the shares cast in the previous year.” In deciding how to vote, ISS considers factors such as disclosed outreach efforts by the board to shareholders in the wake of the vote, the subject matter and the level of support for the proposal in past meetings. To avoid just such a negative reaction from ISS, companies that fail to defeat a shareholder proposal will often take some action in response, whether it be engagement with shareholders or otherwise.

Still, the voting process is dominated by institutional investors, which hold about 70% of outstanding public company stock, compared with only 30% held by retail investors. Moreover, institutional holders participate in voting more heavily, at a rate of 91% compared with only 29% for retail holders. As a result, institutional investors have “a disproportionately large influence over voting outcomes.”

With the prevalence of institutional holders, economic and regulatory factors “have opened the door for third-party proxy advisory firms to play a substantial role in the proxy voting process.” Economically, while huge asset managers, such as BlackRock, can operate independently with their own expert staffs to conduct research and to evaluate proxy issues, for other smaller institutions, the process is “costly and requires significant time, expertise, and personnel….Third-party proxy advisory firms satisfy a market demand by centralizing these costs so they do not need to be duplicated across multiple investment firms.” In addition, from a regulatory perspective, registered institutional investors have certain transparency and fiduciary obligations, which the SEC has indicated can be satisfied by relying on proxy advisory firms, a position that has also increased the influence of these firms.

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In voting client securities, an investment adviser must adopt and implement policies and procedures reasonably designed to ensure that the adviser votes proxies in the best interest of its clients. Prior SEC staff no-action guidance (Egan-Jones Proxy Services, avail. 5/27/04, and Institutional Shareholder Services Inc., avail. 9/15/04) indicated that one way advisers may demonstrate that proxies are voted in their clients’ best interest is to vote client securities based on the recommendations of an independent third party—including a proxy advisory firm—which serves to “cleanse” the vote of any conflict on the part of the investment adviser. Historically, investment advisers have frequently looked to proxy advisory firms to fill this role. As a result, the staff’s prior guidance was often criticized for having “institutionalized” the role of—and, arguably, the over-reliance of investment advisers on—proxy advisory firms, in effect transforming them into faux regulators. As discussed in this Cooley Alert, in response to frequently voiced criticisms that proxy advisory firms wielded too much influence—with too little accountability—in corporate elections and other corporate matters, in 2014, the SEC’s Divisions of Investment Management and Corp Fin issued Staff Legal Bulletin No. 20, “Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms,” which sought to reinforce the responsibilities of investment advisers as voters by reinvigorating their due diligence and oversight obligations with respect to any proxy advisory firms on which they rely. In that guidance, the staff indicated additional steps that an investment adviser could take to demonstrate that proxy votes were cast in accordance with clients’ best interests. In addition, investment advisers were advised to “adopt and implement policies and procedures that are reasonably designed to provide sufficient ongoing oversight of the third party in order to ensure that the investment adviser, acting through the third party, continues to vote proxies in the best interests of its clients,” including measures to identify and address the proxy advisory firm’s conflicts on an ongoing basis. For example, the investment adviser was advised to ascertain, among other things, “whether the proxy advisory firm has the capacity and competency to adequately analyze proxy issues.” (See also this PubCo post.)

But how much influence do proxy advisory firms really have? That seems to be a topic of some debate, largely because it’s difficult to measure how institutional investors, given the same facts, would have voted in the absence of proxy advisors’ recommendations. One study cited in the article estimated that ISS recommendations had limited effect, shifting only 6% to 10% of investor votes. What’s more, institutional investors maintain that they use the recommendations to complement, not substitute for, their own decision-making processes, claiming “that they refer to, but do not rely on, the voting recommendations of proxy advisory firms” and are guided instead by established best practices.

Looking at actual voting outcomes, however, the paper contests that self-assessment, arguing instead that proxy advisors likely have a material, although unspecified, influence over voting behavior:

“An extensive sample of the voting records of 713 institutional investors in 2017 shows that institutional investors are significantly likely to vote in accordance with proxy advisor recommendations across a broad spectrum of governance issues. For example, 95 percent of institutional investors vote in favor of a company’s ‘say on pay’ proposal when ISS recommends a favorable vote while only 68 percent vote in favor when ISS is opposed (a difference of 27 percent). Similarly, equity plan proposals receive 17 percent more votes in favor; uncontested director elections receive 18 percent more votes in favor; and proxy contests 73 percent more votes in favor when ISS supports a measure. While the evidence shows that ISS is the more influential proxy advisory firm, Glass Lewis also has influence over voting outcomes. Glass Lewis favorable votes are associated with 16 percent, 12 percent, and 64 percent increases in institutional investor support for say on pay, equity plan, and proxy contest ballot measures ….Furthermore, some individual funds vote in near lock-step with ISS and Glass Lewis recommendations, correlations that suggest that the influence of these firms is substantial.”

The authors contend that an “extensive review of the empirical evidence shows that an against recommendation is associated with a reduction in the favorable vote count by 10 percent to 30 percent.” According to one study cited in the paper, based on a sample of over 1,300 companies in the S&P 1500, an unfavorable ISS recommendation on a management proposal (such as compensation, antitakeover protections, mergers, and other bylaw-related items) was associated with 13.6% to 20.6% fewer affirmative votes. Looking at the influence of proxy advisory firms on specific matters, the authors conclude, based on cited research, that these firms have a “modest influence” on uncontested elections of directors and a “moderate to large impact” on votes on say on pay and equity comp plans. In the latter case, the authors cited research showing that “shareholders react negatively to the disclosure of plans that meet ISS criteria, and that companies whose plans conform to ISS criteria exhibit lower future operating performance and higher employee turnover.” However, the paper also reported that, based on outside research, that “proxy advisory firms recommendations are beneficial to shareholders in the area of corporate control”; ISS recommendations increased the probability of victory for the dissident slate by 14% to 30%, were “associated with positive shareholder returns” and “may facilitate informed proxy voting.” How to explain these contradictions? The paper suggests that proxy advisory firms may bring greater expertise to bear on more “complex proxy issues, such as proxy contests and mergers and acquisitions.” With regard to other more commonplace issues, “resource and time constraints might compel proxy advisory firms to employ more rigid and therefore arbitrary standards that are less accommodating to situational information that is unique to a company’s situation, industry, size, or stage of growth.”

And it is not just shareholders that are influenced by proxy advisory firms; to win a favorable recommendation, the paper suggests, companies often make governance decisions to conform to proxy advisors’ policy guidelines, particularly on issues such as executive compensation and compensatory plan design. A 2012 survey showed that 72% of public companies “review the policies of a proxy advisory firm or engage with a proxy advisory firm to receive feedback and guidance on their proposed executive compensation plan.” And many companies implement changes in response, including changing disclosure practices, reducing certain benefits or changing the nature of benefits. The authors cite a study of equity comp plan design, which showed that companies tend to design their plans to fall just below ISS limitations.

The extent of the influence exercised by proxy advisory firms amplifies the need for effective policies and voting guidelines, as well as scrupulous objectivity in their application based on meticulous research. Both ISS and Glass Lewis maintain policy guidelines, but, the authors assert, there have been questions raised regarding the rigor and objectivity of their development processes. For example, in 2016, the GAO reported that issuer and investor input, while sought by ISS, was not necessarily incorporated into the final policies. The authors indicate that Glass Lewis does not fully disclose its update process.

Most important, however, according to the authors, is “whether the proprietary models of these firms are effective in identifying companies with governance problems. Neither ISS nor Glass Lewis discloses whether its voting guidelines or historical voting recommendations have been tested to ensure that they are associated with positive future corporate performance, in terms of operating results or stock price returns. This is a notable omission because it is standard practice for research firms to apply back-testing to validate the assumptions in their models. Without comprehensive evidence it is difficult to know whether their voting guidelines are consistent with increased shareholder or stakeholder value.” According to the paper, neither firm discloses its historical recommendation data, contending that this data is proprietary. However, the paper suggests that, after time has elapsed, disclosure should be required to enable independent third parties to conduct “back-testing” to assess the validity of the firms’ models and improve reliability.

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Companies have also certainly voiced complaints about the accuracy of the proxy advisors’ recommendations. For the 2015 proxy season, Nasdaq and the U.S. Chamber of Commerce conducted a survey of public companies to gain insight into companies’ interactions with ISS and Glass Lewis. The survey showed that, for almost all of the surveyed companies, a proxy advisory firm had made a recommendation on a matter in the companies’ proxy statements, and the vast majority (84%) of companies reported that they monitor proxy advisory firms’ reports for accuracy and reliance on outdated information. However, only a quarter of the companies “believed the proxy advisory firm carefully researched and took into account all relevant aspects of the particular issue on which it provided advice.” Surprisingly, only slightly over half the companies notified the advisory firm when the data on which the firm relied in making its recommendation was inaccurate or stale. Although 43% reported these errors to portfolio managers, none “reported bringing this issue to the attention of the SEC.” Almost half the time, companies requested the opportunity to provide input into the recommendation, and advisory firms allowed that input slightly over half the time, allowing anywhere from an hour to a month to respond. Significantly, however, most companies do not believe they are being heard: “[o]nly 38% of companies believe that input had any impact on the final recommendation.” The survey showed that 38% of companies sought to meet and discuss issues subject to shareholder votes with proxy advisory firms, and 60% of those were able to secure a meeting with the firm. Only 20% of companies made formal requests to preview the advisory firm’s recommendation, and just under half were able to obtain a preview. (See this PubCo post.)

Other issues raised in the paper—albeit with the acknowledgement that there is little research to help evaluate these claims—include the absence of any fiduciary duty standard applicable to proxy advisory firm, the absence of any financial incentive to issue accurate recommendations, the presence of conflicts of interest as a result of undisclosed consulting arrangements, and inadequate staffing and other resource constraints. In that regard, the paper compares staffing of 1,000 employees at ISS compared with staffing of 11,700 at Moody’s.

To address these problems, the paper offers two recommendations: first, subject proxy advisory firms to regulation that could include these types of requirements:

Second, eliminate the requirement that institutional holders vote on all proxy items, which, the authors suggest, would allow investors to decide whether or not to buy recommendations from proxy advisors.

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